Cyprus Rescue: The Destruction of a Tax Haven

Cyprus is paying a high price for the $13 billion financial rescue it obtained from the E.U.: the destruction of a key pillar of its economy, its status as the offshore tax haven of choice for wealthy Russians

Cyprus is paying a high price for the $13 billion financial rescue it finally obtained from the E.U. early Monday after a week of high drama: the destruction of a key pillar of its economy, its status as the offshore tax haven of choice for wealthy Russians.

Under the terms of the deal, Cyprus will proceed with a massive cutback of its major banks. The biggest losers will be bondholders and depositors who have more than $130,000 in their accounts; the exact size of their losses still has to be calculated, but it could easily be above 20% and perhaps much higher in some cases. However, smaller depositors with less than $130,000 will be spared, a significant change from the initial rescue deal agreed upon a week ago that was rejected by the Cyprus parliament. Under that arrangement, all bank-account holders would have been taxed, regardless of the size of their deposits, to enable the island to come up with its own $7.5 billion contribution toward the bailout.

The deal still needs to be formally ratified by parliaments in E.U. countries, but — crucially — it has already jumped the biggest hurdle, that of approval in Cyprus itself. On Friday, the island’s parliament approved a range of legislation, including one to restructure the banking sector, which enabled the deal to be sealed.

The overall impact will be a dramatic change for Cyprus’ economy. Over the past 30 years, since the fall of the Berlin Wall, the island has banked on its ability to attract money from Russia and elsewhere as an offshore center. Oversight has been tightened up since Cyprus joined the E.U. in 2004, but it remains relatively lax by international standards, and foreign companies pay a flat tax rate of just 10%. For a while the strategy seemed to work well; Cyprus built up a gargantuan banking industry, which is currently about five times the size of its total economy, according to Standard & Poor’s.

About one-third of the $88 billion in deposits in those banks is from Russians, who have increasingly used the island’s banking system as a tax-sheltered conduit for their financial transactions worldwide. Indeed, Cyprus shows up in international statistics as a huge investor in Russia itself, as a result of “round-tripping” by Russians who didn’t entrust their money to their national banking system. According to European Central Bank statistics, more than 40% of the deposits in Cyprus banks are in excess of $650,000.

All of that is now in tatters. The Russian depositors will take the biggest losses in the bank restructuring, which will effectively shut down the second largest financial institution, Cyprus Popular Bank, better known as Laiki, and merge its “good” assets with those of its larger rival, Bank of Cyprus, which will be revamped. The two banks are in poor shape after suffering heavy losses on their loans to and investments in Greece.

To prevent a massive flight of foreign capital from Cyprus once the banks reopen this week, the government is putting in place some capital controls, which still have to be detailed. Already over the weekend, banks on the island limited ATM withdrawals to about $130 at a time. The imposition of capital controls has sparked some fears among economists of a bigger problem for the euro as a whole, since a single currency cannot function properly if capital cannot move freely. But the E.U.’s Eurogroup — the financial officials from the 17 nations that use the euro — stressed that these measures would be applied in a “temporary, proportionate and nondiscriminatory” fashion, and thus be permitted under existing law.

In the longer term, however, it’s hard to imagine why any Russians would continue to have faith in Cypriot banks. Russian President Vladimir Putin and Prime Minister Dmitri Medvedev both complained publicly last week about the way Russian investors were being treated in Cyprus, and the issue looks likely to become a painful thorn in relations between Russia and the E.U. But Russia itself didn’t heed the pleas for help issued by the Cyprus government last week; Finance Minister Michael Sarris returned from a trip to Moscow empty-handed.

The Cyprus government has agreed to take other significant measures to alter its tax-haven status, according to the Eurogroup statement announcing the deal. One is an independent evaluation of the island’s implementation of anti-money-laundering legislation. Another is an important overhaul of taxation: according to the statement, Cyprus has committed to increase withholding tax on capital income and its 10% corporate tax rate.

The ending of its tax-haven status will force Cyprus to revamp its entire economic strategy, and nobody’s pretending that will be easy. The island has a flourishing tourism industry and is also a shipping hub. But being a tax haven has provided livelihoods for thousands of people, including lawyers and trustees as well as bankers. “The near future will be very difficult for the country and its people,” acknowledged the E.U. Commission’s top economic official, Olli Rehn. “But [the measures] will be necessary for the Cypriot people to rebuild their economy on a new basis.”

In the aftermath of the crisis, once the passions have ebbed, no doubt someone will try to calculate in detail the costs and the benefits to Cyprus of having been an offshore financial haven. Right now, though, it looks like it was a big bust.

Peter Gumbel writes about European business and finance from Paris, where he has lived since 2002. He was worked as a staff writer for The Wall Street Journal, TIME and Fortune. The London-based Work Foundation named him "Journalist of the Year" in 2005.

Gumbel's latest book is France's Got Talent: the woeful consequences of French elitism. A digital version is available in English.